Brokers Update Global And Domestic Equity Strategies

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By Greg Peel

Here we are half way through the dreaded month of May, and Wall Street has hit a new high. The broad market S&P 500 took a bit longer to return to its highs than the Dow Jones Industrial Average given the negative drag most prevalent in the Nasdaq index, with high-PE momentum names being heavily sold down, starting last month but continuing into this month.

Hence so far this year the “Sell in May” adage has been limited to high-flying bio-tech, social media, online and cloud computing names, while more conservative large cap stalwarts have become the beneficiaries of a switch. US investors have turned to “value” in spurning momentum and “growth”. The sell-off in a range of high momentum names has meant these stocks are now equivalently priced to low momentum names, notes Citi. This equivalence is unsustainable in the broker’s view. Citi likes earnings leadership, but feels momentum may be in for a bounce.

As the adverse weather effects of the March quarter fade, Citi is expecting a 3% quarter on quarter rebound in US GDP and beyond. Citi economists have nevertheless left their global growth forecasts unchanged at 3.1% for 2014 and 3.5% for 2015 given below consensus growth forecasts for Brazil, Japan, South Africa and China.

Citi believes the European Central Bank will make good on its threat and cut its cash rate next month given eurozone inflation is set to remain well below target. Stubbornly low inflation should also prompt the ECB into some form of QE later in the year. The economists have slightly lifted their European growth forecasts as a result.

Citi continues to be worried about the risk of further slowdowns in export-oriented economies given sluggish global growth and the prior export outperformance of emerging markets. The Bank of Japan will nonetheless delay further stimulus till later in the year in order to assess whether relative June quarter weakness is all about Tokyo’s consumption tax hike and thus temporary. On the other hand, Beijing is expected to increase stimulus to prevent a sustained slowdown in Chinese growth below 7%.

Amidst widespread debate as to why US Treasury yields remain confusingly low, suggesting a lack of confidence in US growth, while the equity market is hitting new highs, suggesting confidence, Citi offers another more left of field observation. Among all the adages US financial markets have thrown up over the decades, such as “Sell in May”, another is the concept of “Dr Copper”. The basis of this adage is one of the price of copper being a reliable benchmark for US economic growth. Of course, this dates back to when the US economy was unquestionably the world’s most influential, by some degree.

It thus ignores, Citi implies, the fact China is the biggest consumer of the world’s resources these days as it “emerges” to become a mature economy. Citi points out that the US economy can grow even if China’s economy slows, especially if the Chinese government continues to focus on domestic consumer demand and not exports. In other words, a stagnant copper price does not today immediately imply a weak outlook for the US economy. Is this why US yields are so low? Maybe it’s just another of several reasons.

One thing we do know is that with the US quarterly earnings season now all but over, earnings results have beaten forecasts by an average of almost 8% (albeit from much lowered expectations going into the season), revenues have beaten by less than 1% (suggesting earnings continue to be driven by cost cuts and not top-line growth), and forward guidance for the most part has been pessimistic – very pessimistic.

The guidance negatives “massively” outweigh the positives, Citi notes, to the point where the balance is, “incredibly”, comparable to 2008-09 when the US economy was a basket case. On the other hand, many lead indicators suggest improving trends that imply a better second half for US earnings. Thus Citi believes the inflection point for guidance may have been reached.

Meanwhile, the Australian equity market continues to outperform regional and global benchmarks, Morgan Stanley notes. The broker has upgraded its 12-month forecast for the ASX 200 to 5800, representing a 10% total shareholder return (price plus dividends).

Morgan Stanley points out that while Australian investors tend to agonise over the 60% of Australian exports that go to emerging markets (ie China) they tend to neglect the 60% of ASX 200 companies that source revenues from developed markets. In other words, Australia is well positioned for a developed market recovery. And it is this balance that makes Australia attractive to offshore investors as a safe haven against emerging market volatility.

Hence the broker believes a gradual growth adjustment for China is “digestible” for the Australian economy as Chinese structural risks are addressed. Meanwhile the RBA’s easing of the cash rate to a record low is driving a domestic growth cycle independent of the region. There is thus a risk sceptical investors miss out on early-cycle growth opportunities. Morgan Stanley suggests Australia can avoid recession in its transition phase and deliver pockets of revenue and earnings growth, particularly in housing-linked, consumer discretionary and industrial sectors.

On this basis, the broker identifies a bull case argument for Wesfarmers ((WES)), JB Hi-Fi ((JBH)), Asciano ((AIO)), Boral ((BLD)) and Arrium ((ARI)), and a bear case argument for Invocare ((IVC)), Tabcorp ((TAH)), Woolworths ((WOW)), CSL ((CSL)) and SAI Global ((SAI)).

CIMB takes a different approach in suggesting Boral is a good stock to sell at present. The broker notes the aforementioned momentum-for-value switch in the US has also insinuated itself into Australia, which the broker thinks is not a bad thing at a time markets are directionless and global growth remains uncertain. On this basis CIMB prefers resources and domestic cyclicals over banks, consumer staples, utilities and telcos on a 12-month horizon, although the broker admits the momentum-value switch is more of a stock specific exercise.

Selling out of momentum in a relatively expensive market should be easy, says CIMB, and Boral and CSR ((CSR)) stack up on this front as well as Iluka Resources ((ILU)) and David Jones ((DJS)). To sell out of DJs one might simply wait for the takeover to complete but the broker suggests both it and Brambles are showing relatively weak earnings prospects and stretched valuations.

In terms of value with earnings certainty, CIMB likes Cabcharge ((CAB)), Trade Me ((TME)), Skilled Engineering ((SKE)), Orica ((ORI)), OZ Minerals ((OZL)) and Fortescue Metals ((FMG)), while Fortescue and Orica pop up again on the broker’s strong earnings growth outlook radar, along with ResMed ((RMD)), Nufarm ((NUF)), Envestra ((ENV)), M2 Telecommunications ((MTU)), Echo Entertainment ((EGP)), Transfield ((TSE)) and UGL ((UGL)).

Given extensive debate about Australian corporate price/earnings (PE) being too high for many names, Deutsche Bank has decided to have a closer look. Dividing the ASX 100 into five PE quintiles, the analysts find that the top quintile is indeed comparatively expensive at a multiple of 22x versus the historical average 20x, but that all quintiles are indeed 7-10% above historic averages. Such lack of dispersion suggests a lack of specific overvaluation.

[Bear in mind that not all sectors or stocks start with the same average PE. Different industries are priced differently for a balance of risk and growth opportunity, such that risky, cyclical miners tend to have low PEs, reliable cashflow businesses higher PEs and strong structural growth stories the highest PEs, for example.]

Deutsche Bank suggests the market might be worried that so many cyclicals have seen PE increases [when cyclicals should have on average lower PEs than non-cyclicals] such that 80% of the top quintile are now cyclicals, up from 55% at the start of 2013. But there has been an improvement in cyclical earnings to justify the re-rate, the broker points out. Indeed, the broker suggests the top quintile looks “fine” in terms of PE.

On the other hand, Deutsche believes the bottom quintile is “worth a look”. The broker’s model portfolio includes bottom quintile names Lend Lease ((LLC)), Orica, QBE Insurance ((QBE)) and Rio Tinto ((RIO)), while the analysts also like Downer EDI ((DOW)), Myer ((MYR)) and Regis Resources ((RRL)).

Nevertheless, notes Macquarie, more recently the market return has stalled as valuations ease despite improved earnings momentum. This is not a concern as such moves are typical in a cycle. In the early phase of an expansion, prices run ahead of earnings (PEs run up) before earnings can catch up (PEs ease). Macquarie sees the net rise in PEs overall as not something to be concerned about but rather a shift to more “normal” levels as developed world economies recover.

The Australian market’s FY14 earnings forecast continues to hold up above 10% growth (currently 13.2%), the broker notes, which is a big improvement on the 3.1% earnings decline booked in FY13. This is mostly due to a large jump in the earnings outlook for resources to 45% growth while at 5% growth, the forecast for the market ex-resources matches the FY13 result.

Morgan Stanley suggests the current 14.6x one year forward earnings multiple looks “fair”, but allows little room for disappointment. While consensus is for strong FY14 earnings growth, there is little conviction for FY15-16 where forecasts suggest only single digit gains. There is room for upgrades, the broker suggests, if these early signs of successful transition away from mining are sustained.

There is nevertheless a reasonable amount of faith being placed in the “2H Club”, Morgan Stanley notes, being those stocks with a typical second half skew in earnings. Those stocks with the largest 2H skews are Transfield, Cochlear ((COH)), WorleyParsons ((WOR)), Mermaid Marine ((MRM)) and Navitas ((NVT)).

Credit Suisse has had a look at “crowded trades”. It’s a simple theory – when everyone gets on board the same story there is a much amplified risk of reversal if that story fails to play out, thus investors must be wary of trades that become too crowded. CS has sourced IRESS numbers for long-only institutional investors and ASIC data for short-enabled hedge funds.

While one might expect the greatest risk to come from sharp short-covering rallies, the broker finds it is the crowded long trades that are most prone to reversal risk. There are many fewer investors who play the short side than the long side, so it does make sense. And of course, there’s also the stairs/elevator adage with regard panic selling.

So which are the “crowded” trades at present? In ASX 100 stocks, Credit Suisse identifies Mineral Resources ((MIN)), Metcash ((MTS)), Monadelphous ((MND)) and Aurora Oil & Gas ((AUT)) on the long side [note AUT is under takeover] and Arrium on the short side. In the Small Ordinaries CS identifies Ausdrill ((ASL)), Western Areas ((WSA)), Shopping Centres Australia ((SCP)), Cabcharge, SMS Management & Technology ((SMX)), Imdex ((IMD)) and Atlas Iron ((AGO)) on the long side and Paladin Energy ((PDN)), iProperty Group ((IPP)), Iress ((IRE)), Retail Food Group ((RFG)), Buru Energy ((BRU)), Mt Gibson Iron ((MGX)), Webjet ((WEB)) and BWP Trust ((BWP)) on the short side.

Goldman Sachs has reviewed its Focus List of preferred stocks and notes two constituents – CSL and Austbrokers Holdings ((AUB)) – have underperformed the ASX 200 by 10% and 16% respectively in the last three months. Goldman’s conviction has not waned, so the broker implies these two are even more of a Buy now. The broker also throws in a special mention for Domino’s Pizza ((DMP)), which is on the broker’s SUSTAIN Focus list and remains a valuable investment in the broker’s opinion.

Finally, Citi has taken on board the recent jump in global merger and acquisition activity in looking at which companies – big companies – across the globe might satisfy the broker’s M&A target criteria of valuation, funding and confidence. And I mean big. The list includes Hewlett-Packard, Shell, BP, and Maersk.

It also includes Rio Tinto and Woodside Petroleum ((WPL)).
 

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